Funds of private equity funds have been regarded like a dog walker, performing a useful service for multiple clients but potentially holding too many leads. After a tenfold increase in number in little more than a decade, funds of funds managers are preparing for consolidation.

Many are grappling with issues such as overcommitting to private equity firms and gearing their assets. There are 298 managers with active funds of funds, according to data provider Preqin. This is up from 27 fund managers in 1996.

More than half of the managers –185 – are trying to raise $65bn (€51bn) in funds. However, Preqin said by the start of this month only 63 funds had closed, raising $22.9bn, compared with 134 with $63.8bn of assets in the whole of last year.

Tim Friedman, head of publications and marketing at Preqin, said: “After a record year in 2007, raising funds of funds has been much more challenging in 2008. The drop in fundraising is more due to the tough fundraising climate than any drop in managers seeking capital.

“The final quarter is traditionally strong as managers seek to close vehicles before the year ends, and we would expect a relatively large amount of funds to close in December, bringing the total up to around the $30bn to $35bn mark.

“We have seen a shift towards bigger managers and bigger funds in recent years, which follows a trend we have seen in the private equity industry as a whole.”

Managers expect a wave of consolidation. Hamish Mair, head of private equity funds at UK asset manager F&C Investments, said: “In the fund of funds tier, consolidation into bigger groups has been overdue for some time.

“There are too many funds of funds with perhaps one big client, not much track record and sometimes a not very tried and tested process. These will struggle to raise significant funds in more arduous fundraising conditions and consolidation is an obvious route from here.”

George Anson, managing director at HarbourVest, said: “Clearly critical mass, ie, minimum funds under management, is the first gating factor, and we are seeing consolidation in the German space for this very reason. That seems very rational. Beyond that, it is being able to address client needs. Being the lowest cost provider is a good entry point, but it may not make for a sustainable business model. You get what you pay for.”

Mair warned consolidation of managers was difficult. He said: “Consolidation has been unusual in the private equity industry generally. This is probably due to the nature of the relatively small owner-managed firms, where the principals often have histories with big organisations and don’t want to repeat this. They value the control over their own destinies and they generally don’t have financial pressures. The net result is that they would rather wither away or break up than merge with an erstwhile competitor.”

He said there was a difference in mindset between private equity firms investing in companies and fund of fund managers, with the latter being asset managers by nature rather than deal doers. Mair said this gave funds of funds “a more natural disposition towards consolidation, which builds up assets under management”.

The pension fund selected Capital Dynamics for a $150m mandate to invest in buyout funds in the Asia-Pacific region. Judy Saunders, chief investment officer at the West Midlands Pension Fund, said the decision to move from Gartmore was because of consolidation of the pension fund’s management arrangements. She did not rule out investing in Gartmore funds in future. Gartmore declined to comment.

At the end of 2006, Preqin said nearly three quarters of funds of funds picked managers in the top half of performance tables and so, after fees, they delivered returns comparable with the average direct private equity fund.

However, by dint of their diversification, the top quartile of funds of funds showed markedly lower returns than the best 25% of direct managers, according to Preqin.

Friedman said: “There is also a strong continuance of good performance among different funds managed by the best managers, ie, the best managers consistently raise the best funds. In 53% of cases, top-quartile managers see their follow-on fund also appearing in the top quartile, and only appearing in the bottom quartile in 5% of cases. They are beating the median in 77% of cases. That’s very high.”

To boost returns and based on historic patterns of capital returns and investments, funds of funds had “overcommitted” to private equity, according to Christopher Brown, head of investment companies research at Cazenove. Overcommitment levels are defined as the amount of capital promised to underlying funds that is not covered by current cash balances and unused loan facilities, expressed as a proportion of net assets.

He said: “Funding these capital calls, therefore, could become a challenge and we have already seen some companies effectively forced to sell fund interests at discounts in order to improve their balance sheets. Specifically for this reason, we downgrade F&C Private Equity and Standard Life PE from in line to underperform as they have high overcommitment levels.

These issues may not necessarily be a problem for the trusts, but we believe there is a risk the discount could widen in the shorter term as investors focus on those trusts with high levels of overcommitments.”

Iain Scouller, an analyst at UBS, said: “A significant increase in private equity-backed company defaults is likely in 2009 with some decline in earnings and more debt servicing problems being inevitable. Many quoted private equity funds have substantial commitments to finance and are now leveraged. We wonder whether, at some point, the whole industry will declare ‘force majeure’ on commitments.”

Last week, David Rubenstein, co-founder of buyout firm Carlyle Group, told its investors it would be “flexible” and work with investors over the commitments made as investors “may be challenged in meeting capital calls” but Carlyle expected these drawdowns to be infrequent, said one investor on the conference call. Carlyle declined to comment.

The head of a private equity firm that has just completed its latest fundraising said he had been worried by funds of funds and others potentially reneging on commitments. As a result, he had limited the fund’s investors to one fund of funds that specifically used no leverage to boost an overcommitment strategy in order to reduce the risk of an investor defaulting on its promises.

However, this approach can usually be applied only by the most successful private equity firms that are oversubscribed for fundraising, although this group was growing, according to one head of a bank’s European financial sponsors and placement business. He said this was because investors were fleeing to quality.

Katharina Lichtner, a managing director at Capital Dynamics, said: “There will be a flight to quality. The top managers will be even more restricted despite wider problems in the fundraising market. We don’t overcommit and we don’t put leverage on top.” There are some that have done that and they are starting to have trouble. Funds of funds are not set up to deal with liquidity issues, a manager said.